Buy a bond portfolio of marketplace loans or high yield ones?

After over around 6 months of closely monitoring Lending Club’s activity we have observed that it behaves as a borrower’s market.

Virtually all loans issued by Lending Club get funded… and rather quickly. At the interest rates set by Lending Club, there has been clearly more offer than demand. As proven by their track record, Lending Club does a great job filtering loan applicants (with an acceptance rate of around 20%), which makes yield-hungry lenders willing to take whatever Lending Club shows them. Lending Club therefore focuses on offering rates that are competitive when compared to the borrower’s alternatives… counting on the lenders to fund anything they issue. They focus exclusively on attracting borrowers, to the extent that they even tend to offer “x.99%” rates to make them appear lower.
This borrower dominance of the market can also be seen in the issued loan rates and their correlation -or lack thereof- with the markets. While classic (corporate and government) bonds react instantly to changes in interest rates or credit risk premiums, Lending Club’s rates remain impassible to economic conditions. As an example, during January’s turmoil, with interest rates dropping sharply, equities plunging and credit spreads shooting up dramatically, most of Lending Clubs effective rates remained unchanged, and those who did move showed only a minimal response. This probably can happen only because the usual retail lender’s alternative, bank deposits, are just as impervious to short term market conditions, so they will continue to take their money to Lending Club.
Credits spreads of Leding Club B2 bonds vs high yield bonds
Credits spreads of Leding Club B2 bonds vs high yield bonds
However with Marketplace Lending growing its borrower base at an extraordinary rate, and with institutional investors entering the scene, this may all change some day.
As huge sophisticated investors increase their participation in the marketplace, they will easily become the main source of loan funding, The difference will be that they will not be comparing rates with deposits or other stable, market-independent retail alternatives… they will be looking for something to beat the bond market.
Lending Club at some point might have to addapt to the maturing of the asset class, shifting some focus from borrowers to lenders when setting their rates by keeping an eye on the market. If they don’t keep rates competitive against bonds at all times, a credit spread spike in the bond market could cause an instant drought in their platform, as these huge, ruthless players take their money to more productive assets.

How profitable is the Marketplace Lending Asset Class?

Marketplace Lending (platforms that do disintermediate banks by connecting investors with loan seekers) is going to be in 2015 between 1 and 2% of consumer credit in the US. And it is growing at 100% per year. So if we do a very simple math, we can conclude that in less than 10 years it will take 10% of the consumer credit market in the US away from banks. And now we are talking real money…This is the time when banks will begin to lobby to increase the regulation of these new players that take advantage from not having deposit takers, and therefore be subject to a very light regulation.

Why does it grow so much? The reason varies by geography, but overall it can be reduced to two main reasons on the loan seeker side:

  • It is cheaper for the loan seeker. This is specially true in the US, where marketplace lending is basically a proxy for revolving credit cards and loan consolidation. How much cheaper? In the order of 5-10% (500 to 1.000 bps) per year, depending on the credit profile. Definitely a very good reason for a loan seeker to change from a bank to a lending platform.
  • It is faster than a bank and more convenient. This is specially true for the UK where banking regulation, KYC processes and legacy score systems make the loan process extremely cumbersome. A normal bank, if it does not know the client can take anything from a week to well over a month. In marketplace lending, platforms can grant a loan in anything from a few minutes to a little over a week.

But why it grows so much on the investor side? The reason is basically the stability of returns across the interest rate cycle, and the extra interest that investors are getting for comparable risk.

On the stability of returns, we can see the chart below. We have built a theoretical marketplace lending asset class index (composed of the main lending platforms in the US and UK weighted by their size) and we can see that as interest rates go down, returns for marketplace investors remain stable.

Marketplace Lending Asset Class Profitability

Extra Profitability of Market Place Lending
Source: Indexa Lending

Also, I can argue that the average investor is buying a B4 years type of bond when he buys on a diversified way a basket big enough of loans (since our market place lending index yields an average 4-5% delinquency ratio per year), see chart 2 below. Under this scenario, we can also see that market place lending is yielding 1-2% per year extra interest for the same risk. No wonder investors are buying it…

Global Bond Default Ratios in the 20th Century

Delinquency Ratios per type of Bond in the 20th Century (Moody's)

Another topic is how to measure correctly profitability of the marketplace lending platforms. But that will be part of another post.